What Is an Overheated Economy?

An Overheated Economy Explained

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An overheated economy is when the economy grows too fast. An overheated economy reaches the limits of how much output it can produce to meet the demand from consumers and businesses, as there are very little unused resources. This typically occurs when the economy is employed beyond what is considered “full employment.”

Here’s how that works and what happens when the economy is overheated.

Definition and Examples of an Overheated Economy

An overheated economy is one in which output is above potential output or unemployment is lower than the natural rate of unemployment (NRU). Both can happen when the economy grows too fast.

Potential output is the output an economy can sustainably produce given the available amount of resources such as workers, technology, and equipment. The NRU is the lowest level of unemployment an economy can have without creating inflation. It is also called “full employment” and it is considered to be between 4% and 6% in the U.S. An overheated economy is one in which the economy is growing beyond a sustainable rate.

The problem with an overheating economy is that supply can’t keep up with the demand for goods. This can result in rapid price increases, then businesses may offer higher wages to attract workers, which further pushes up prices. If the general price level rises enough, it creates inflation, which can hurt economic growth.

An example of an overheated economy is the period surrounding the financial crisis between 2007 and 2009. Prices rose rapidly in the U.S. and annual inflation was 2.9% in 2007 and 3.8% in 2008, which is higher than the target inflation rate the central bank sets at 2%. The unemployment rate was 4.6% in 2007, which was also on the low end of (or below) the NRU. The unemployment rate eventually rose to 5.8% in 2008 and over 9% in 2009 and 2010, and inflation dropped back down below 2%.

How Does an Overheated Economy Work?

Typical signs that an economy may be overheating are rising wages and prices due to an increase in lending. If interest rates are low for a prolonged period of time, consumers and businesses may borrow money to spend on goods and investments. The increased demand for consumer goods and assets leads to higher prices. The rise in asset prices encourages more lending as people feel wealthier, creating a feedback loop than can generate an asset bubble.

Asset bubbles may occur when the economy is overheated. An asset bubble is when the price of an asset rises, but the rise in price is not attributed to an increase in the underlying value of the asset.

For example, the low interest rates preceding the U.S. financial crisis between 2007 and 2009 contributed to an overheated economy as more people borrowed money to buy real estate (due to the lower costs of borrowing). Prices on real estate began to rise, creating an asset bubble—often referred to as the housing bubble.

When an asset bubble bursts, asset prices will collapse, and lenders will cut back on how much credit they let people borrow. The housing bubble ultimately burst, and by 2012, many cities saw home prices fall. From 2006 to 2012, housing prices fell 62% in Las Vegas, 54% in Phoenix, and 50% in Miami. This type of situation not only hurts banks that are not paid back on mortgage loans they extended, but also the economy as a whole as lending and investment fall.

How Do You Cool an Overheated Economy?

One way for central banks to cool an overheated economy is to use tight monetary policy. Tight monetary policy attempts to slow down inflation and make it more expensive for consumers and businesses to borrow money. This will decrease the demand for consumer goods and assets.

An example of tight monetary policy would be raising interest rates. For example, the U.S. central bank (the Federal Reserve) could raise the federal funds rate; this influences other interest rates in the economy, such as mortgage rates and bank loans, to help make it more expensive for consumers and businesses to borrow money. This could help cool an overheated economy.

Is the U.S. Economy Overheated?

While the Federal Reserve maintained that the U.S. economy was not overheating and inflation was temporary in 2021, there were signs that the economy was beginning to overheat.

In a Federal Reserve report from July 9, 2021, the Fed showed the increase in demand for goods and the decrease in the supply of goods due to materials and labor shortages. As a result, prices began to increase, and by the fall, inflation was at a high not seen since June 1982.

In November 2021, inflation reached 6.8% and the unemployment rate was 4.2%. Global demand also surged in 2021 due to many stimulus measures and low interest rates. This pushed up prices on many consumer goods and assets even more. In response to the added wealth of businesses, the wages of workers increased. Workers had more money to spend by the end of 2021, and demand was further pushed up. In addition, there were and still are supply chain bottlenecks due to a shortage of workers and raw materials, which has further pushed up prices and contributed to inflation. These were all contributing factors to the rapid rise in prices in 2021—a typical sign of an overheated economy.

In December 2021, the Fed released a statement acknowledging the imbalance between supply and demand. While it maintained a low federal funds rate of between 0% and 0.25%, it did state that it was prepared to change that rate if and when the labor market reached levels in line with its ideal employment.

Key Takeaways

  • An overheated economy is an economy that is producing beyond its potential output or beyond full employment. It shows that the economy is moving too fast.
  • A rapid increase in prices is a main sign that an economy is beginning to overheat.
  • An overheated economy is typically caused by an increase in demand for goods due to low interest rates.
  • A central bank can help mitigate the potential effects of an overheated economy by raising interest rates.